The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Sunday, February 3, 2013

The Question the UK's Commission on Banking Standards should ask bankers

The Guardian carried an article in which it suggested a number of questions that the Parliamentary Commission on Banking Standards should ask the senior banking executives from Barclays, HSBC and Lloyds at the hearing this week.

These questions include:

■ Has the go-for-broke bonus culture on the City's trading floors really changed? What are they doing to enforce different values?
■ How have they shifted incentives, from boardroom to branch, to prevent another major mis-selling scandal on the scale of PPI or interest-rate swaps?
■ Once the Vickers reforms are enacted, will it really be the case, as George Osborne hopes, that banks' investment arms can be allowed to go bust without inflicting huge collateral damage on the rest of the economy?
■ How can they justify the continued existence of a lavish bonus culture, despite the fact that tens of thousands of layoffs mean there should be bankers aplenty to snap up on the cheap?
■ Why was lending to small and medium-sized businesses still falling at the end of 2012, despite cut-price loans from the government's Funding for Lending Scheme?
■ Even if Osborne fixes the problem of banks being too big to fail, aren't they still simply too big to manage?

All of these are excellent questions, but they are follow-on questions to the real question:

What are you hiding that prevents you from adopting ultra transparency and disclosing on an ongoing basis your current global asset, liability and off-balance sheet exposure details?

Since at least the 1900s, ultra transparency has been the sign of a bank that can stand on its own two feet as it shows that the bank has nothing to fear because it has nothing to hide. Clearly, the UK banks are hiding behind a veil of opacity that the Bank of England's Andrew Haldane says makes the banks 'black boxes'.

What are the banks hiding?

Since the 1930s, it has been well known that sunlight is the best disinfectant. However, the bankers are not using sunlight but rather policy pronouncements to try to change their culture. Policies that a Guardian poll showed that almost 3 out 4 people do not think will be effective at Barclays.

If the bankers are truly serious about changing their culture, why are they not deploying ultra transparency which is the best means for changing the culture and keeping future bankers from straying into bad behavior?

Please note that by asking about ultra transparency several of the Guardian's questions don't need to be asked.

The issue of whether a bank is too big to manage goes away as a result of subjecting the banks to the type of market discipline that ultra transparency makes possible. For the first time since the 1930s, market participants will be able to assess the risk of each bank and adjust the amount and price of their exposure to reflect this risk assessment. Linking risk and cost of funds will an incentive for banks to make themselves manageable (banks perceived to be too big to manage will pay a premium to obtain funds).

Can a bank's investment arm go bankrupt ceases to be a major issue when there is ultra transparency as the investment arm will no longer take proprietary bets. It won't take proprietary bets because all of the market participants can see their position and can trade in such a way as to minimize the potential profit of the position and maximize the potential loss on the position (please see JP Morgan Whale trade for confirmation).

The existence of a lavish bonus culture doesn't need to be justified as providing ultra transparency allows the Board to link pay to risk adjusted performance. The Board will do this as market participants will exert discipline on the bank to do so.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.